What is Yield Farming?
Decentralized Finance, shortly termed as DeFi is an open-source protocol that provides permissionless and fast financial services. The process by which users provide liquidity to DeFi open-source protocols and get rewards is termed as DeFi Yield Farming.
In simple terms, the process of yield farming carried out on platforms that are built using DeFi protocols offers native DeFi tokens of that particular platform and this process is known as DeFi Yield Farming.
We already know that DeFi has been a trending business topic since late 2021, and now this DeFi Yield Farming is sparkling as a light in every headline of recent crypto news.
This shows that DeFi Yield Farming has caught sight of crypto wizards and it will make them shift to the next level in the crypto market sooner.
Yield farming protocols, in short, encourage liquidity providers (LPs) to stake or lock up their crypto assets in a smart contract solution-based liquidity pool. A proportion of transaction costs, interest from lenders, or a governance token may all be used as rewards. These returns are calculated as a percentage yield on an annual basis (APY). The value of the released returns rises as more investors allocate funds to the associated liquidity pool.
The majority of yield farmers initially staked well-known stablecoins such as USDT, DAI, and USDC. The most common DeFi protocols, on the other hand, now run on the Ethereum network and offer governance tokens for liquidity mining.
What is Liquidity?
In general, Liquidity refers to the ability of the asset to be converted to cash. In the crypto globe, the market becomes competitive when an asset gets bought or sold more. Thus, liquidity means that there isn’t any discount or premium related to the buy or sell of any asset, which implies that the ability to enter or exit the crypto market is easy.
What are DEFI Liquidity Pools?
Liquidity Pools are smart contracts that lock up tokens or assets to facilitate trading by providing high liquidity. Liquidity Pools also are known as pools of tokens or pools of assets offer users better returns as compared to money markets but involve certain risks.
Uniswap and Balancer are the most popular DeFi platform termed as the largest liquidity pools which provide liquidity providers reward for adding their assets to the pool.
Who are DeFi Liquidity Providers?
The process of yield farming is nothing without Liquidity Providers. The users who stake their assets in the liquidity pools are known as liquidity providers. This process of collection of orders facilitates trading in cryptocurrency through the creation of a market. Thus, liquidity providers are also termed as market makers, as they supply what buyers and sellers want to trade.
How Does DeFi Yield Farming Works?
Yield farming referred to as Automated Market Maker, is nothing without the involvement of liquidity providers and liquidity pools.
First and foremost, the liquidity providers deposit or send their assets or funds to the liquidity pool. This liquidity pool provides a marketplace where users or LPs can lend, borrow or exchange their tokens or assets. These platforms collect fees which are then paid back to the liquidity providers based on their share of the liquidity pool.
However, working can vary with different technologies and approaches. The funds deposited are mostly stablecoins pegged to USD. DAI, USDT, BUSD are the most commonly used stablecoins in DeFi yield farming.
How Are Returns Calculated in DeFi Yield Farming?
The Estimated returns in Yield farming are calculated on an annual basis. The most important metrics in the calculation of returns in yield farming are the Annual Percentage Rate (APR) and Annual Percentage Yield (APY).
The common difference between both APY and APR is that APY accounts for the effect of compounding while APR does not. Compounding refers to reinvestment profits to generate more returns.
Annual Percentage Yield (APY)
The annual rate of return charged on borrowers and paid to providers subsequently refers to the Annual Percentage Yield.
Annual Percentage Rate (APR)
The annual rate of return imposed on borrowers and paid to the investors is termed the Annual Percentage Rate. Since APR and APY come from legacy markets, DeFi should find its own metrics for the calculation of returns in yield farming.
This is how the returns are calculated in the DeFi Yield Farming.
Risks in DeFi Yield Farming
Everything in the universe involves risks, though life and thus Yield Farming too. Since DeFi is in its infant stage, there are more failures in DeFi products as it is completely permissionless.
Thus, yield farming with DeFi also involves risks, as farming involves depositing funds to a smart contract. This virtual process involves two anonymous parties with no central authority. And if the smart contract codes are lost and found to be an error, the entire financial transaction will also be lost. This implies that the funds transferred will be lost. This makes yield farmers lose all their assets if the system is blocked.
When the DeFi smart contracts are free from vulnerabilities, the risks involved in DeFi yield farming can be reduced.
What Sparked the Rise of High-Yield Farming?
The introduction of the COMP token – the Compound Finance ecosystem’s governance token – has sparked a surge of interest in yield farming. Token holders get governance privileges for governance tokens. However, the question is the distribution of these tokens happens while keeping the network decentralized?
Distributing these governance tokens algorithmically with liquidity bonuses is a common way to kickstart a decentralized blockchain. Liquidity providers are enticed to “farm” the new token by providing liquidity to the protocol.
Although the COMP didn’t invent yield farming, it did raise the popularity of this form of token distribution model. Other DeFi ventures have also devised creative ways to draw liquidity to their ecosystems.
What are the Advantages and Disadvantages of Yield Farming?
Profit is one of the most obvious advantages of yield farming. Yield farmers who are among the first to implement a new project may be rewarded with tokens that rapidly appreciate. Huge gains can be made if they sell certain tokens at the right time. Those profits can be re-invested in other DeFi projects to increase yield even more.
Yield farmers must typically invest a substantial amount of money upfront to make any significant profits — even hundreds of thousands of dollars may be at stake. Yield farmers face a major liquidation risk if the price drops unexpectedly, as it did with HotdogSwap, due to the highly volatile nature of cryptocurrencies, particularly DeFi tokens.
Also, the most effective yield farming techniques are complicated. As a result, those who don’t completely comprehend all of the underlying protocols are at greater risk.
Yield farmers have put their money on the project teams and the smart contract code that underpins them. Many developers and entrepreneurs are drawn to the DeFi space because of the opportunity for profit. They start projects from the ground up or even copy the code of their predecessors. Even if the project team is trustworthy, the code is often untested and prone to bugs, making it vulnerable to attackers.
Key Challenges and Opportunities with Yield Farming
The Ethereum blockchain is used for the majority of DeFi applications, posing some significant challenges for yield farmers. The Ethereum network is experiencing scalability issues ahead of the 2.0 update. As yield farming becomes more common, the Ethereum network becomes clogged, resulting in long confirmation times and rising transaction fees.
As a result of this scenario, some have speculated that DeFi could end up self-cannibalizing. Ethereum’s problems, on the other hand, seem to be more likely to support other networks in the long run. The Binance Smart Chain, for example, has emerged as a viable alternative for yield farmers who flocked to the network to take advantage of new DeFi DApps like BurgerSwap.
Additionally, Ethereum’s existing DeFi operators are attempting to solve the problem with their second-layer solutions for the network. As a result, assuming that Ethereum’s issues do not prove fatal to DeFi, yield farming will continue to exist for some time to come.
The five Yield Farming Protocols
To maximize the returns on their staked funds, yield farmers will frequently use a variety of DeFi platforms. These platforms include a variety of incentivized lending and liquidity pool borrowing options. Here are seven of the most popular yield farming techniques.
It is a money market for lending and borrowing funds, where users can gain algorithmically modified compound interest as well as the COMP governance token.
It is a decentralized credit pioneer that allows users to borrow DAI, a USD-pegged stablecoin, by securing crypto as collateral. A “stability tax” is charged in place of interest.
It is a decentralized lending and borrowing protocol that allows users to borrow assets and receive compound interest for lending using the AAVE (previously LEND) token. Aave is also known for promoting flash loans and credit delegation, in which borrowers can receive loans without putting up any collateral.
is a well-known decentralized exchange (DEX) and automated market maker (AMM) that allows users to swap almost any ERC20 token pair without the use of a third party. Liquidity providers must stake 50/50 on both sides of the liquidity pool to gain a share of transaction fees and the UNI governance token.
It is a decentralized automated aggregation protocol that allows yield farmers to use different lending protocols such as Aave and Compound to get the best yield. Yearn. finance uses rebasing to optimize the benefit of the most efficient yield farming services.
Curve, Harvest, Ren, and SushiSwap are some other notable yield farming protocols.
For more information about Yield Farming, you may connect with our blockchain and cryptocurrency development experts. They possess the requisite knowledge and expertise in the domain of decentralized finance.
Popular DeFi Yield Farming Platforms
There are many yield farming platforms and protocols available in the DeFi market. Each platform has its own rules and risks with different yield farming strategies.
The Future of DeFi Yield Farming
The above-listed DeFi Yield farming provides better yields for their farmers which makes uncountable new users to those platforms each day. This process of Yield Farming is driving the DeFi space to the next level in the crypto market.
In the future, there may be more and more DeFi based platforms inherited with automated yield farming that will tend to rock the crypto globe. This yield farming has inspired many individuals and yet to attract many in the nearer future.